Market Outlook: Inflation jitters

Market Outlook: Inflation jitters

Investors are usually worried about something -- if not growth then inflation -- and October's leap in inflation, the biggest jump in 25 years, has rattled equity markets worldwide. However, investors' main concern is not the acceleration in inflation but rather policymakers' likely reaction.

At least the nomination of White House insider and academic, Ben Bernanke, to the Chairmanship of the Federal Reserve, helped to reassure investors that there would not be too much of a change in the path of policy when the current chairman, Alan Greenspan, retires early next year. Nevertheless, cautious comments from Federal Reserve in recent weeks have fuelled speculation that US interest rates will peak at a higher level than investors had been expecting.

Another reason for the market's nervousness is the continuing low level of real interest rates. Every interest rate hike from the Federal Reserve has been matched by an acceleration in inflation, leaving real interest rates little higher than when the Federal Reserve first began tightening policy and far lower than the neutral rate considered consistent with stable inflation. However, the recent jump in headline inflation is entirely the result of the increase in gasoline prices in the wake of hurricanes Katrina and Rita.

Excluding volatile energy and food prices, underlying inflation is a less threatening 2.0 per cent and has actually softened lately. Low underlying inflation is little cause for comfort if firms begin to pass on higher fuel costs to consumers, or if workers ask for higher wages to compensate. At present, there is little evidence that this is happening and wage inflation has been slowing all year.

Moreover, with wholesale gasoline prices having now fallen back to the level at which they stood in July, before Katrina struck, the jump in energy costs ought to dissipate over the next few months.

This will help to bring headline inflation back down again and reduce the risk of firms passing on higher energy costs.

Consequently, although policymakers cannot afford to relax their guard, equity markets may have got a little carried away and the recent pickup in inflation does not herald sharply higher interest rates.

Speculation that the Federal Reserve might have to raise interest rates a little higher than expected has helped to support the US dollar, but even without much further tightening, the interest rate outlook would remain very favourable for the currency. However, while inflation concerns have pushed 10-year government bond yields up to 4.5 per cent from 4.0 per cent at the end of August, US bond yields still have further to rise before they look attractive compared to bond markets elsewhere, given higher US inflation. Equities also continue to look better value than government bonds.

Nevertheless, although higher interest rates and energy prices have appeared to have remarkably little impact on activity, the economic climate does not look sufficiently upbeat to lift Wall Street out of the doldrums. Consumer confidence has plunged in the wake of the hurricanes, and although factory orders and business confidence are very strong, the economic climate is once again looking more doubtful. Moreover, investment analysts have turned more uncertain about the outlook for corporate profits and have started downgrading their profit forecasts for the first time in a year. In addition, with stock markets worldwide following the US market lower, US equities still appear to offer worse value than markets elsewhere.European recovery gathers momentum Like their counterparts in the US, European investors have become more preoccupied with the outlook for inflation in recent weeks.

The European Central Bank's (ECB) mandate is to keep headline inflation below 2.0 per cent in the medium term and the recent acceleration in inflation to 2.6 per cent raises the likelihood of an early interest rate rise. However, as in the US, ignoring the jump in energy costs, underlying inflation is relatively subdued with prices just 1.3 per cent higher than a year ago. In Germany, underlying inflation --at just 0.6 per cent -- is even tamer. Nevertheless, in recent weeks the ECB has turned more hawkish, emphasising the need for "strong vigilance" with regard to the inflation outlook. The ECB's more cautious tone has persuaded the money markets that it will raise interest rates before the end of the year.

This turnaround in expectations has pushed government bond yields a little higher, but the 3.4 per cent 10-year yield remains exceptionally low by international standards. Moreover, the economic recovery continues to build momentum; not only are exports accelerating but retailers are beginning to see stronger demand. The recovery appears to be spreading throughout the economy with construction orders at their strongest since 2001 and the outlook for the German service sector its most upbeat in five years. For the moment, the recovery is still largely confined to Germany but the economic climate is looking better all the time.

Fuelled by strong profit growth and continuing attractive valuations, European markets have performed strongly this year.

The improvement in the economic environment should help to give these markets a further boost over the coming months and they still look good value following their recent slide. Bond yields, on the other hand, still appear exceptionally low compared to markets elsewhere given the pickup in the economic climate and the prospect that the ECB will tighten policy in the coming months.

The likelihood of a rise in euro zone interest rates means that the interest rate outlook is now less of a burden for the euro. However, sentiment is weak and the jump in oil prices this year continues to weigh on the currency. The Swiss franc is more attractive as it is buoyed by stronger sentiment and looks more undervalued.

Bank of Japan predicts the end of deflation

In recent months, Japan's recovery has attracted much conjecture and comment, with the pick up in consumer spending particularly provoking speculation that this time the recovery can be sustained.

The Bank of Japan has also become more optimistic and is confidently predicting an end to deflation, in which the country has been mired since 1998, before the end of the year. A return to inflation would signal that the current recovery is more than just another flash-in-the-pan. It would also allow the Bank of Japan to consider raising interest rates above 0 per cent during the second half of next year.

Although the economic climate has improved since the beginning of the year, there is little sign that deflation has begun to ease.

Underlying inflation, ignoring swings in energy and food prices, is still -0.3 per cent and there is not much evidence that price pressures are building up earlier in the supply chain. Whereas consumer spending has been surprisingly upbeat, manufacturing output has remained listless. Moreover, with stocks of unsold goods rising and foreign machinery orders still cooling, industrial production is likely to remain fairly sluggish. Therefore, although the restructuring that Japanese firms have undertaken in recent years means that the Japanese economy looks much better placed for a sustained recovery, there are still doubts as to whether that recovery has yet begun.

Nonetheless, the improvement in the economic climate has boosted sentiment towards Japanese equities. Foreign investors continue to pour money into the stock market and volumes are buoyant, signalling that confidence is returning. Analysts are also relatively upbeat on the outlook for Japanese firms' profits. However, until the recovery looks more assured, government bonds look more attractive. With prices still falling, it remains likely to be some time before the Bank of Japan begins raising interest rates.

Consequently, the rise in Japanese government bond yields looks a little premature and after allowing for Japan's lower inflation rate, bond yields look attractive by international standards. Moreover, the zero per cent money-market yield is set to remain a hurdle for the Japanese yen. Therefore, although the pick up in activity has boosted the Tokyo stockmarket, the Japanese yen looks set to remain out of favour.

Prospects of a UK interest rate cut recede

Over the past year, the UK economy has grown at its slowest rate for nearly a decade as the downturn in the housing market has sapped the consumer boom. However, there are signs that the outlook is a little brighter. Growth in the third quarter, while still below the trend rate at 0.4 per cent, was better than had been expected, particularly given the GBP 1.4 billion cost incurred by Lloyd's of London in settling insurance claims arising from Hurricane Katrina. This alone knocked 0.1% off UK growth in the third quarter. Exports have surged in the past few months and are growing at the fastest rate since the collapse of the technology bubble in 2001. Moreover, estate agents are reporting a pick up in enquiries and that house prices are rising again. This is despite house prices remaining stretched at more than five times average earnings. In addition, retail sales have generally strengthened a little even though the mild and wet autumn weather is holding back sales of new clothing. However, the pick up in mortgage approvals in recent months suggests that activity both in the housing market and on the high street should strengthen further over the coming months.

The better economic news is unlikely to provide much comfort for the Chancellor of the Exchequer. Halfway through the fiscal year, disappointing growth in corporate tax revenues means that the budget deficit looks on course to undershoot the chancellor's forecast by GBP 10 billion and remain around 3 per cent of economic output.

At some point, the chancellor will need to plug this deficit and this will require the equivalent of a 3p rise in the basic rate of income tax. Nevertheless, keen not to damage his credibility before the prime minister steps aside, the chancellor looks set to insist for now that the public finances are in good shape and that there is no need to raise taxes. Given the strength of demand for gilts, particularly from UK pension funds, higher government borrowing is unlikely to lead to higher bond yields. With UK government bonds still offering attractive yields compared to markets elsewhere, particularly after allowing for inflation, UK government bonds remain good value.

The more stable economic climate and acceleration in inflation have poured cold water on the money market's hopes of an interest rate cut before the end of the year. Moreover, the minutes from October's meeting of the Monetary Policy Committee revealed a surprising level of agreement with regards to the decision not to cut interest rates, given previous disagreements on the need for further interest rate cuts. Whilst fading speculation of a cut in interest rates will disappoint borrowers, it will help to support the pound despite its continued overvaluation. Nevertheless, while the relatively high level of interest rates is good for the pound, it will continue to hamper the stock market. Furthermore, whereas investment analysts elsewhere in Europe are upgrading profit forecasts, UK analysts are downgrading forecasts. In combination with investors that are content to sit on the sidelines, weak sentiment is set to remain a drag on the UK stock market. Although the UK may have passed the worst, the economic climate now looks stronger elsewhere. This is particularly the case in comparison to the euro zone and together with the hurdle from higher interest rates, the UK market looks likely to lag.